On Models of Stochastic Recovery for Base Correlation

Li, Hui (2009): On Models of Stochastic Recovery for Base Correlation.

Abstract

This paper discusses various ways to add correlated stochastic recovery to the Gaussian Copula base correlation framework for pricing CDOs. Several recent models are extended to more general framework. It is shown that, conditional on the Gaussian systematic factor, negative forward recovery rate may appear in these models. This suggests that current static copula models of correlated default and recovery processes are inherently inconsistent.

• Item Type: MPRA Paper
• Language: English
• Keywords: CDO, Gaussian Copula, Base Correlation, Stochastic Recovery, Correlated Loss Given Default
• Subjects: G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

S. Amraoui, S. Hitier (2008): Optimal Stochastic Recovery for Base Correlation. defaultrisk.com.

L. Andersen, J. Sidenius (2004): Extensions to the Gaussian Copula: Random Recovery and Random Factor Loadings. Journal of Credit Risk 1(1), pp. 29-70.

C. Ech-Chatbi (2008): CDS and CDO Pricing with Stochastic Recovery. SSRN working paper.

J. Frye (2000): Collateral Damage. RISK 13(4), pp. 91-94.

S. Höcht, R. Zagst (2009): Pricing Distressed CDOs with Stochastic Recovery. defaultrisk.com.

M. Krekel (2008): Pricing Distrressed CDOs with Base Correlation and Stochastic Recovery. defaultrisk.com.

Y. Li (2009): A Dynamic Correlation Modelling Framework with Consistent Stochastic Recovery. defaultrisk.com.

M. Pykhtin (2003): Unexpected Recovery Risk. RISK 16(8), pp. 74-78.

D. Tasche (2004): The Single Risk Factor Approach to Capital Charges in case of Correlated Loss Given Default Rates. Working paper, Deutsche Bundesbank.

J. Witzany (2009): Loss, Default, and Loss Given Default Modelling. Working paper, IES.